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The major purpose of financial markets is to transfer funds from lenders to borrowers. Financial market participants commonly distinguish between the "capital market" and the "money market," with the latter term generally referring to borrowing and lending for periods of a year or less. In the money markets, banks lend to and borrow from each other, short-term financial instruments such as certificates of deposit (CDs) or enter into agreements such as repurchase agreements (repos). It provides short to medium term liquidity in the global financial system. Money market derivatives include forward rate agreements (FRAs) and short-term interest rate futures. Trading takes place between banks in the "money centers" (New York and London primarily, also Chicago, Frankfurt, Paris, Singapore, Hong Kong, Tokyo, Toronto, Sydney, San Francisco). There are several different instruments in the money market, offering different returns and different risks. In the following sections, we'll take a look at the major money market instruments.
Bankers' Acceptance - A draft or bill of exchange accepted by a bank to guarantee payment of the bill.
A bankers' acceptance starts as an order to a bank by a bank's customer to pay a sum of money at a future date, typically within six months. At this stage, it is like a postdated check. When the bank endorses the order for payment as "accepted", it assumes responsibility for ultimate payment to the holder of the acceptance. At this point, the acceptance may be traded in secondary markets much like any other claim on the bank. A bankers' acceptance (BA) is a short-term credit investment created by a non-financial firm and guaranteed by a bank to make payment. Acceptances are traded at discounts from face value in the secondary market. For corporations, a BA acts as a negotiable time draft for financing imports, exports or other transactions in goods. This is especially useful when the creditworthiness of a foreign trade partner is unknown. One advantage of a banker's acceptance is that it does not need to be held until maturity, and can be sold off in the secondary markets where investors and institutions constantly trade BAs. A certificate of deposit (CD) is a time deposit with a bank. CDs are generally issued by commercial banks but they can be bought through brokerages. They bear a specific maturity date (from three months to five years), a specified interest rate, and can be issued in any denomination, much like bonds. Like all time deposits, the funds may not be withdrawn on demand like those in a checking account. CDs offer a slightly higher yield than T-Bills because of the slightly higher default risk for a bank but, overall, the likelihood that a large bank will go broke is pretty slim. Of course, the amount of interest you earn depends on a number of other factors such as the current interest rate environment, how much money you invest, the length of time and the particular bank you choose. While nearly every bank offers CDs, the rates are rarely competitive, so it's important to shop around. A fundamental concept to understand when buying a CD is the difference between annual percentage yield (APY) and annual percentage rate (APR). APY is the total amount of interest you earn in one year, taking compound interest into account. APR is simply the stated interest you earn in one year, without taking compounding into account. (To learn more, read APR vs. APY: How The Distinction Affects You.) The difference results from when interest is paid. The more frequently interest is calculated, the greater the yield will be. When an investment pays interest annually, its rate and yield are the same. But when interest is paid more frequently, the yield gets higher. For example, say you purchase a one-year, $1,000 CD that pays 5% semi-annually. After six months, you'll receive an interest payment of $25 ($1,000 x 5 % x .5 years). Here's where the magic of compounding starts. The $25 payment starts earning interest of its own, which over the next six months amounts to $ 0.625 ($25 x 5% x .5 years). As a result, the rate on the CD is 5%, but its yield is 5.06. It may not sound like a lot, but compounding adds up over time. The main advantage of CDs is their relative safety and the ability to know your return ahead of time. You'll generally earn more than in a savings account, and you won't be at the mercy of the stock market. Plus, in the U.S. the Federal Deposit Insurance Corporation guarantees your investment up to $100,000. Despite the benefits, there are two main disadvantages to CDs. First of all, the returns are paltry compared to many other investments. Furthermore, your money is tied up for the length of the CD and you won't be able to get it out without paying a harsh penalty. Commercial paper is a money market security issued by large banks and corporations. It is generally not used to finance long-term investments but rather for purchases of inventory or to manage working capital. It is commonly bought by money funds (the issuing amounts are often too high for individual investors), and is generally regarded as a very safe investment. As a relatively low risk option, returns are not large. Because commercial paper maturities don't exceed nine months and proceeds typically are used only for current transactions, the notes are exempt from registration as securities with the United States Securities and Exchange Commission. Currently more than 1,700 companies in the United States issue commercial paper. Financial companies comprise the largest group of commercial papers issuers, accounting for nearly 75 percent of the commercial paper outstanding at mid-year 1990. Financial-company paper is issued by firms in commercial, savings and mortgage banking; sales, personal and mortgage financing; factoring; finance leasing and other business lending; insurance underwriting; and other investment activities. The remaining commercial paper outstanding at mid-year 1990 -- over 25 percent -- was issued by nonfinancial firms such as manufacturers, public utilities, industrial concerns and service industries. For many corporations, borrowing short-term money from banks is often a laborious and annoying task. The desire to avoid banks as much as possible has led to the widespread popularity of commercial paper. (See Why do companies issue bonds instead of borrowing from the bank?) Commercial paper is an unsecured, short-term loan issued by a corporation, typically for financing accounts receivable and inventories. It is usually issued at a discount, reflecting current market interest rates. Maturities on commercial paper are usually no longer than nine months, with maturities of between one and two months being the average. For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months. Furthermore, typically only companies with high credit ratings and credit worthiness issue commercial paper. Over the past 40 years, there have only been a handful of cases where corporations have defaulted on their commercial paper repayment. Commercial paper is usually issued in denominations of $100,000 or more. Therefore, smaller investors can only invest in commercial paper indirectly through money market funds. Historically, such deposits were held mostly by European banks and financial institutions, and thus became known as "eurodollars". As of April 2006, China holds the largest foreign exchange reserves, much of which are denominated in US currency. Such deposits are now available in many countries worldwide, but they continue to be referred to as "eurodollars" regardless of the location. In the USA, the term eurodollar is sometimes confused with the joint European currency, the Euro. Contrary to the name, eurodollars have very little to do with the euro or European countries. Eurodollars are U.S. dollar-denominated deposits at banks outside of the United States. This market evolved in Europe (specifically London), hence the name, but eurodollars can be held anywhere outside the United States. The average eurodollar deposit is very large (in the millions) and has a maturity of less than six months. A variation on the eurodollar time deposit is the eurodollar certificate of deposit. A eurodollar CD is basically the same as a domestic CD, except that it's the liability of a non-U.S. bank. Because eurodollar CDs are typically less liquid, they tend to offer higher yields. The eurodollar market is obviously out of reach for all but the largest institutions. The only way for individuals to invest in this market is indirectly through a money market fund. In the United States, federal funds are bank reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions. Transactions in the federal funds market enable depository institutions with reserve balances in excess of reserve requirements to lend reserves to institutions with reserve deficiencies. These loans are usually made for 1 day only, i.e. "overnight." The interest rate at which these deals are done is called the federal funds rate. Federal funds transactions neither increase nor decrease total bank reserves. Instead, they redistribute reserves and enable otherwise idle funds to yield a return. Banks may borrow fed funds to avoid an overdraft (i.e. the balance going below zero) of their reserve account, or in order to meet the reserves required to back their deposits. Fed funds are good money, meaning that they are available for immediate spending, while checks and many other forms of money must be cleared by banks and typically take several days before becoming available for spending. Participants in the federal funds market include commercial banks, savings and loan associations, government sponsored enterprises, branches of foreign banks in the United States, federal agencies, and securities firms. Many relatively small institutions that accumulate reserves in excess of their requirements lend reserves overnight to money center and large regional banks, as well as to foreign banks operating in the United States. Federal agencies also lend idle funds in the federal funds market.
Repurchase agreements (RPs or Repos) are financial instruments used in the money markets. A more accurate and descriptive term is Sale and Repurchase Agreement, since what transpires is sale of securities now for cash by party A (the cash borrower) to party B (the cash lender), with the promise made by A to B of repurchasing those securities later (with A paying the requisite implicit interest to B at the time of repurchase - the implicit interest rate is known as the repo rate). There is little that prevents any security from being employed in a repo; so, Treasury or Government bills, corporate and Treasury / Government bonds, and stocks / shares, may all be used as securities involved in a repo. Normally, both parties view the transaction from the trader's perspective. A trader looking to borrow money is transacting a repo, while a trader looking to obtain securities is executing a reverse repo. When a customer provides money to a trader in return for securities, the transaction is often termed a repo by both parties. A repo is similar to a secured loan, with the lender of money receiving securities as collateral to protect against default. The legal title to securities passes from the seller to the investor. The one providing the cash is referred to as an "investor"; the provider of the collateral is the "seller". Coupons that are paid out on the securities during the life of the loan are generally passed directly onto the seller of the Repo. It is possible to instead pass on the coupon by altering the cash paid at the end of the agreement, though this is more typical of Sell/Buy Backs. Typically, repos are short-term, either overnight, or with a maturity of few days. However, repo agreements up to 3 months are not uncommon; these can be used to cover futures contracts, and are commonly called term repos. Repo is short for repurchase agreement. Those who deal in government securities use repos as a form of overnight borrowing. A dealer or other holder of government securities (usually T-bills) sells the securities to a lender and agrees to repurchase them at an agreed future date at an agreed price. They are usually very short-term, from overnight to 30 days or more. This short-term maturity and government backing means repos provide lenders with extremely low risk. Repos are popular because they can virtually eliminate credit problems. Unfortunately, a number of significant losses over the years from fraudulent dealers suggest that lenders in this market have not always checked their collateralization closely enough. There are also variations on standard repos: * Reverse Repo - The reverse repo is the complete opposite of a repo. In this case, a dealer buys government securities from an investor and then sells them back at a later date for a higher price. A Reverse Repo is the repo as seen from the point of view of the cash lender, since the cash lender does not repurchase, but rather has securities repurchased from (i.e. the cash lender is the passive party in the act of securities repurchasing). * Term Repo - exactly the same as a repo except the term of the loan is greater than 30 days. Treasury Bills (T-bills) are the most marketable money market security. Their popularity is mainly due to their simplicity. Essentially, T-bills are a way for the U.S. government to raise money from the public. In this tutorial, we are referring to T-bills issued by the U.S. government, but many other governments issue T-bills in a similar fashion. T-bills are short-term securities that mature in one year or less from their issue date. They are issued with three-month, six-month and one-year maturities. T-bills are purchased for a price that is less than their par (face) value; when they mature, the government pays the holder the full par value. Effectively, your interest is the difference between the purchase price of the security and what you get at maturity. For example, if you bought a 90-day T-bill at $9,800 and held it until maturity, you would earn $200 on your investment. This differs from coupon bonds, which pay interest semi-annually. Treasury bills (as well as notes and bonds) are issued through a competitive bidding process at auctions. If you want to buy a T-bill, you submit a bid that is prepared either non-competitively or competitively. In non-competitive bidding, you'll receive the full amount of the security you want at the return determined at the auction. With competitive bidding, you have to specify the return that you would like to receive. If the return you specify is too high, you might not receive any securities, or just a portion of what you bid for. (More information on auctions is available at the TreasuryDirect website.) The biggest reasons that T-Bills are so popular is that they are one of the few money market instruments that are affordable to the individual investors. T-bills are usually issued in denominations of $1,000, $5,000, $10,000, $25,000, $50,000, $100,000 and $1 million. Other positives are that T-bills (and all Treasuries) are considered to be the safest investments in the world because the U.S. government backs them. In fact, they are considered risk-free. Furthermore, they are exempt from state and local taxes. (For more on this, see Why do commercial bills have higher yields than T-bills?) The only downside to T-bills is that you won't get a great return because Treasuries are exceptionally safe. Corporate bonds, certificates of deposit and money market funds will often give higher rates of interest. What's more, you might not get back all of your investment if you cash out before the maturity date.
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